Working Paper Series no. 825: The Case for a Positive Euro Area Inflation Target: Evidence from France, Germany and Italy

This paper estimates the optimal inflation rate that minimizes the welfare consequences of distorted relative prices in France, Germany and Italy. Prices of goods and services can get distorted by inflation whenever nominal prices are ‘sticky’, e.g., when they adjust only infrequently over time. In such a situation, inflation can cause the relative price of goods to drift: positive rates of inflation, for instance, cause the relative price of goods to fall over time in the absence price adjustments; likewise, deflation causes the relative price of goods to increase over time.

In light of this, the present paper answers a simple question: what drift in relative prices should monetary policy implement in order to maximally align prices with their efficient values? It shows that price stickiness makes it optimal to target positive rates of inflation in all three countries considered. This is optimal because it is efficient - on average across products - that relative product prices fall over time, albeit at different speeds across countries.

This finding represents a significant departure from standard arguments made in the sticky price literature, which - for its vast majority - rely on models that do not allow for efficient trends in relative prices (on average across products). As a result, standard models conclude that the optimal inflation rate is zero or very close to zero. The present paper shows that this is far from true: price stickiness alone causes an inflation rate between 1.1% and 1.7% to be optimal in the Euro Area.

Clearly, a complete consideration of the question of the optimal inflation target must also take other aspects into account that are not accounted for within the present paper. These considerations comprise the desire to avoid hitting the lower bound constraint on nominal interest rates, the desire to avoid deflation in individual countries forming a heterogeneous currency union, and a range of other factors from which the present paper abstracts. This said, the optimal inflation rates estimated in the present paper shift an important cornerstone determining the optimal inflation target within such a more complete analysis.

Considering the micro price data underlying the construction of the Harmonized Index of Consumer Prices (HICP) in France, Germany and Italy the paper estimates the efficient rates of relative price increase/decrease over the product life cycle for a large set of products. While the efficient relative price trends differ widely across different product categories, they show considerable persistence over time and display common patterns across countries. In particular, the relative price of goods falls rather strongly over the product lifetime in all countries, even if this effect is somewhat less pronounced in Italy. The relative price of services, however, is largely stable over the product lifetime (France and Italy) or even slightly increases over time (Germany). Taken together these facts imply that the efficient relative price falls, on average across goods and services, so that a significantly positive rate of inflation is optimal in all three countries. Figure A reports the expenditure-weighted distribution of optimal inflation rates at the product level for the 3 countries and shows that within each country, the optimal inflation rate varies considerably across expenditure categories, but that more expenditure weight is located in the area where optimal inflation is positive. 

If the central bank targets an inflation rate of zero in such a setting, as would be prescribed by standard sticky price models that do not allow for trends in relative prices, then this generates considerable distortions in relative prices and an increase in average mark-ups. As a result, economic welfare declines by several percentage points in consumption-equivalent terms. Targeting an inflation rate of zero would thus be severely suboptimal.